Private Credit’s Balancing Act: Stability Masks Deepening Cracks

NEW YORK, NY – December 05, 2025 – The private credit market, a nearly $2 trillion behemoth that has reshaped corporate finance, is sending mixed signals as it heads into 2026. On the surface, a recent analysis from Kroll Bond Rating Agency (KBRA) paints a picture of resilience for Business Development Companies (BDCs), the publicly traded vehicles that offer investors a window into this opaque world. The verdict: a “generally stable” outlook, underpinned by strong liquidity and manageable leverage.

But beyond the headlines, a more complex narrative is unfolding. This surface-level stability masks a widening dispersion in performance, emerging cracks in asset quality, and a brewing dilemma over shareholder dividends. While the industry remains well-capitalized to navigate uncertainty, the coming year will test the prowess of even the most seasoned managers as they balance risk and reward in a shifting economic landscape.

The Dividend Dilemma: A Shifting Payout Landscape

For years, BDCs have been a haven for income-seeking investors, offering juicy dividend yields often exceeding 5%. That core appeal is now facing its most significant test in recent memory. According to KBRA’s third-quarter 2025 compendium, dividend coverage has become a primary concern for equity investors, prompting a strategic pivot across the sector.

Competitive pressures have squeezed lending spreads, and with the Federal Reserve widely expected to enact several rate cuts through 2026, the era of soaring net investment income (NII) fueled by high base rates is drawing to a close. In response, BDCs are proactively adjusting their payout strategies. Some are reducing or eliminating the supplemental and special distributions that became common during the rate-hike cycle. Others are taking more structural steps, with several BDCs reducing their base dividends to align with lower long-term rate expectations.

A telling example of this strategic shift is FS KKR Capital Corp (FSK), one of the industry's largest players. The company is moving to a lower fixed dividend supplemented by a variable component tied directly to credit performance, an explicit acknowledgment of the performance challenges and rising non-accruals impacting its portfolio. This move highlights the “idiosyncratic pressures” KBRA noted, where specific portfolio issues are forcing difficult choices.

This trend creates a clear divergence in the market. On one side are firms like FSK adjusting to new realities. On the other are industry bellwethers like Ares Capital (ARCC), which has famously maintained a more conservative fiscal strategy, prioritizing steady growth and a well-covered base dividend over chasing higher payouts with special distributions. This bifurcation underscores a crucial reality for 2026: not all BDCs are created equal, and their approach to capital distribution is becoming a key differentiator.

Beneath the Surface: Cracks in Asset Quality Emerge

While KBRA found that the vast majority (93.7%) of investments across its rated universe are performing at or above expectations, the agency also flagged “signs of late-cycle softening.” The most concrete evidence lies in the rising number of loans on non-accrual status—meaning the borrower is over 90 days past due and the lender is no longer recording interest income.

For non-perpetual BDCs, the median value of these troubled loans increased to 2.5% of total investments at cost, a noticeable year-over-year uptick. While still historically low, this creep is a tangible sign that the prolonged period of high interest rates has taken a toll on some middle-market borrowers. The “selective borrower underperformance” mentioned in the report is no longer a theoretical risk but an emerging reality.

BDCs’ core strengths, however, provide a significant buffer. Portfolios are highly diversified and heavily weighted toward first-lien senior secured loans, placing them at the top of the capital stack in case of a default. Furthermore, a strategic focus on less cyclical sectors like software and healthcare services provides insulation from broader economic downturns. This defensive positioning is why, despite the increase in non-accruals, rating outlooks remain stable for now. The question for 2026 is whether this softening is a containable issue affecting a few over-leveraged companies or the leading edge of a broader credit downturn.

The Engine of Resilience: Funding, Liquidity, and M&A

If rising non-accruals represent the primary risk, then BDCs' formidable access to capital is their greatest strength. The industry is not facing a cash crunch; in fact, it is flush with liquidity. Favorable market conditions in 2025 allowed BDCs to execute robust unsecured debt issuance, expand their bank credit facilities, and increase the formation of middle-market collateralized loan obligations (CLOs).

This proactive liability management has enabled firms to refinance near-term obligations and extend their debt maturities, creating a strong financial foundation to weather potential storms. The deep relationships between large BDC managers and major banks have proven invaluable, ensuring access to capital even as market sentiment fluctuates. This financial firepower allows BDCs not only to support struggling portfolio companies but also to deploy “dry powder” into new opportunities created by market dislocation.

Fueling further optimism is the resurgence in mergers and acquisitions. After a sluggish period, both corporate and private equity dealmakers anticipate a significant increase in M&A volume and value in 2026. This is critical for BDCs, as a healthy M&A market provides the primary exit route for their investments, allowing them to realize gains and recycle capital. It also generates a steady stream of new lending opportunities as PE sponsors and corporations seek financing for acquisitions, creating a virtuous cycle for private lenders.

Navigating the 2026 Headwinds

Looking ahead, the path for BDCs is one of cautious navigation. The macroeconomic environment presents a dual-edged sword. Expected interest rate cuts from central banks will ease financing costs for portfolio companies, but they will also directly compress the net investment income that funds BDC dividends. Meanwhile, persistent geopolitical risks—from U.S.-China trade friction to global instability—remain a significant wildcard that could disrupt supply chains and roil markets with little warning.

The industry's future trajectory hinges on balancing these forces. The structural tailwind of private credit’s growth, fueled by the retreat of traditional banks from middle-market lending, remains firmly in place. Yet the widening gap between the strongest and weakest performers shows that success is not guaranteed. For investors and market watchers, the key will be to look beyond the stable façade and scrutinize the underlying health of loan portfolios and the prudence of dividend policies, as these are the factors that will ultimately separate the resilient from the vulnerable in the year to come.